Demonetisation: Precipitating a Recession

(The following is a transcript of the speech given by Prof. Prabhat Patnaik at Jawaharlal Nehru University, New Delhi, in the wake of the central government’s decision to demonetise 500 and 1000 rupee notes. Prabhat Patnaik is a renowned economist and thinker. He is Professor Emeritus at Jawaharlal Nehru University and author of several books including The Value of Money, The Retreat to Unfreedom and A Theory of Imperialism.)

The decision which was taken on the 8th to demonetise 500 and 1000 rupee currency notes was a decision, the main rationale for which was that it is going to affect the black money economy, that it is going to have an adverse impact on black money.

Now I think basically there is a very widespread misconception about black money, and this decision suggests that the misconception also affects the highest levels of the government. Now this misconception is the following: that we think of black money as basically a whole stash of currency notes which are put in suitcases or put in pillow cases or put in trunks or put underground etc. That the whole notion of black money is a stash of currency notes. Now that is completely wrong. In fact, if that was the case then the problem of black money wouldn’t be serious, which it is, because black money really itself is a misnomer. It is not a term which is very properly, appropriately used. But basically when we talk of black money we refer to a whole range of activities. Those activities are either illegal or those activities are undeclared, because those who get profits out of those activities don’t want to pay taxes. Therefore really it is a set of activities very much like the activities which are known, declared and which constitute our GDP. When we talk of GDP we think in terms of a whole range of activities which are going on in the economy. Likewise there are a whole lot of other activities going on in the economy which are undeclared. Now those other activities are undeclared partly because they may refer to illegal activities like drug running or arms smuggling or gold smuggling or whatever. They may be undeclared because of the fact as I said to avoid taxes, they may be undeclared like illegal mining because you are actually exceeding whatever you are supposed to mine. So for a variety of reasons there are a whole lot of activities that are undeclared, and those activities really constitute the black activities.

So when we think of black money, it is not a stock, it is not a stock, it is actually a flow. There is a continuous set of activities that are generating incomes that are employing people but on the other hand that employment and that income is undeclared, is unrecorded in our official statistics or in government's reckoning.

In fact, Marx had once said that really the difference between the capitalist and the miser is that the miser believes that you can become rich by hoarding money; while the capitalist believes that you can become rich only by throwing money back into circulation. Now when we are talking about black activities, black economy operators, they are capitalists, they are not misers. Therefore the whole idea is that they actually have to throw this money continuously back and consequently that is how they generate their incomes.

So if you think in terms of black money in terms of black activities, then simply even getting hold of a stash of notes that may happen to exist is not going to stop those activities. Those activities occur because it is profitable for them to occur.
Now in any activity there is always a certain amount of stock holding. When the Sardarji out there in the Kamal Complex [a shopping complex in JNU] is carrying on the activity of trade, he has a whole lot of inventories that he holds regularly. Likewise in every activity there is a certain amount of cash that is regularly held; there is a certain amount of money that is regularly held. Now exactly in the same way, when we are talking about black activities there is also a certain amount of money that is regularly held, there is a certain amount of cash that is regularly held. But it is not that this cash holding constitutes the black economy, but rather this cash holding is only something which in the process of circulation of cash in the black economy, occasionally gets congealed in particular spots.

In fact, Marx had once said that really the difference between the capitalist and the miser is that the miser believes that you can become rich by hoarding money; while the capitalist believes that you can become rich only by throwing money back into circulation. Now when we are talking about black activities, black economy operators, they are capitalists, they are not misers. Therefore the whole idea is that they actually have to throw this money continuously back and consequently that is how they generate their incomes.

So if you only think in terms of demonetising currency notes and you think thereby you have destroyed or smashed the black economy, then you are betraying a conception of the black economy that is completely wrong. It is not just the holding of currency notes, but black economy is a whole set of activities.

Now let’s see, can it be that this entire set of activities can actually be hampered in some way if you, for instance, even impound some of these currency notes or declare it illegal? So it may be that even attacking this might actually upset the entire set of activities. Is that possible?

Well let’s just look at some figures. Firstly of course, in a capitalist economy, if it is the case that suddenly you find that some currency notes have become demonetised. But obviously it is not as if you can’t exchange them, but you can exchange them only under certain conditions, with certain restrictions. Then you would find that a whole lot of fellows would come up who would then say, “Okay, give me your 1000 dollar note, I will give you 700 dollars and I will get it exchanged!” In other words, that is what Schumpeter had called the innovation in the capitalist economy. Namely, that actually you have a proliferation of black activity that occurs because of this attack on black money and that is already something that you can read in newspapers and so on. These days I am told that the rate going is 700 rupees for changing a 1000 rupee note. So, far from actually attacking the black economy, it would actually give a rise to the proliferation of the black economy.

But suppose let us say there is nonetheless some loss on the part of the existing operators of the black economy. Then this loss on their part, the loss of 300 when you are actually giving a 1000 rupee note and getting 700, really accrues to some other black operator. It is not something which is really making any difference to the size of the black economy, but it accrues to some other black operator. But let us say, nonetheless, let us say that a part of this black money, this stock of cash actually gets destroyed.

Let’s see, let’s just look at some possible figures. Now, a lot of people say that about a quarter of the Indian economy is actually the black economy. That would make the size of the black economy about 30 lakh crores or 35, let’s just say 30 lakh crores. It is amazing that the government to this day does not actually have any idea how much cash holding amounts to in the black economy. I said that the black economy does not consist only of cash holding, nonetheless there is some cash holding. The government still has no idea how much this actually amounts to. The figure which generally is floating around is about three and a half lakh crores.

Now if you have a 30 lakh crore black economy, precisely because the black economy is one where you have high levels of profits and capital gains, let’s say roughly about 15 lakh crores or in the very least about 10 lakh crores would constitute every year the profits and capital gains in the black economy. Out of the three and a half lakh crores, some would of course be converted into all kinds of new legal tender. But maximum let’s say about a third is something that is lost to the black operators. That would mean about 1 lakh crore. So in an economy where you have annual profits of about 10 lakh crores, a loss of 1 lakh crore basically amounts to a 10% loss in your annual profits. Now with this you are not going to be destroying the black economy. And consequently, the fact that such drastic measures are taken in order to attack the black economy, which actually amounts not to an attack but at the most to a pin-prick is indicative of the lack of understanding that actually currently permeates even the highest circles of the government.

At one stroke, you have actually impounded 85% of the currency that is with the public. It actually if you take the currency-deposit ratio that exists in the economy, it amounts to 12% of the total money supply. So you have at one stroke destroyed 12% of the money supply of the economy and 85% of the currency. Now this amounts to taking away the purchasing power from the hands of the people which amounts to as much as 85% of the currency in circulation. Taking away this purchasing power immediately implies that it precipitates a recession in the economy.

Now, of course, this is not the only argument, there are certain other arguments. One argument for instance is that there is a lot of counterfeit currency. Now if there is counterfeit currency, by the way, there is nothing to guarantee that the new currency also would not be counterfeited. But suppose it is the case, there is a lot of counterfeit currency, and you want to convert it. You don’t have to do it overnight. It’s not as if on the 8th the government has any information that suddenly there is going to be a flood of counterfeit currency coming into the market. This is something which you could have done over a period of time exchanging existing legal tender for new legal tender. After all this has happened in the past, it keeps happening all the time. I mean you know, when I was young we had naya paises and so on, you had old paisa and then moved to a metric system etc. This keeps happening. So the idea that this has to be done overnight is an idea which actually has absolutely no rationale whatsoever. So this on the one hand suggesting that this is going to deal a blow to the black economy and suggesting that counterfeit currency made this absolutely essential. None of these arguments, to my mind, carries any intellectual conviction at all.

On the other hand, look at the damage it has actually done to the economy, because the 500 and 1000 rupee notes as you know amounts now to about 85% of the currency with the public. At one stroke, you have actually impounded 85% of the currency that is with the public. It actually if you take the currency-deposit ratio that exists in the economy, it amounts to 12% of the total money supply. So you have at one stroke destroyed 12% of the money supply of the economy and 85% of the currency. Now this amounts to taking away the purchasing power from the hands of the people which amounts to as much as 85% of the currency in circulation.

Taking away this purchasing power immediately implies that it precipitates a recession in the economy, because that vegetable seller who is giving me credit, for instance, on the basis of which I buy my vegetables and I have been surviving, that vegetable seller himself has to get credit in order to give me credit. Now that is going to dry up in a couple of days time, and if it dries up, in that case he is out of his business. So you have now a situation where a very serious recession is going to occur precisely because you suddenly have impounded 12% of the total money supply of the economy, and what is more, this recession would particularly affect the smaller ones, who don’t deal in credit cards, who don’t deal in bank cheques and so on, who actually deal in currency.

You know, I have been thinking about it; the only comparable case I can think of is after the Battle of Plassey in Bengal. Shortly after 1757, in the 1760s and 70s in Bengal under colonial rule, what happened was, that because of the drain, there was a shortage of specie, you know those days gold and silver constituted the basis of the currency, and there was a sudden drop in the availability of gold and silver and it precipitated a severe recession in Bengal at the beginning of colonial rule. Such a sharp fall in money supply, declared overnight, obviously has very serious repercussions on the economy and particularly on the poorer segments of the people, for which the only comparable example I can think of is in Bengal after the Battle of Plassey.

Now of course this is supposed to be a part of a general transition to a cashless economy. Now I think it is symptomatic of the utter callousness - and that is a very mild word - of the Indian elite, that actually they think of such terms, they think of such objectives and so on. The United States, the mightiest capitalist economy in the world, is not a cashless economy. And no target has been set, a date by which the US is going to become cashless. You go to the US, you have dollars, you spend dollars. You have a cup of tea, you pay by dollars etc.

So this whole absurdity of a cashless economy that they are going to have is something which is not only an absurdity, but it is really going to affect large numbers of very poor people. Because they are not the ones who are going to be eligible for credit cards; they are the people who really require cash. They are the ones who actually operate an economy with cash. So if you say a cashless economy, then in effect you are dealing a heavy blow to that economy of tiny producers, of petty producers, of small producers - the pan wallahs etc etc. Now just imagine, at this very moment, if you cannot buy vegetables from the local thela [push cart used by small vegetable sellers etc] or from the local vegetable shop, then perforce you have to go to Modern Bazaar or some such place where they accept credit cards. Now that which is now a temporary situation, hopefully, will actually become a permanent situation because if you’re going to have a cashless economy, then effectively you have to deal with credit cards and so on, and a whole lot of people would get completely excluded.

Besides, even if you wish to have a cashless economy, this should be a progress that occurs on its own. You don't force people. It is the height of authoritarianism to impose measures on people and say, “You are going to have a cashless economy.” It is just absurd. It is something which is unthinkable. And yet that is exactly what is happening.

So this whole absurdity of a cashless economy that they are going to have is something which is not only an absurdity, but it is really going to affect large numbers of very poor people. Because they are not the ones who are going to be eligible for credit cards; they are the people who really require cash. They are the ones who actually operate an economy with cash. So if you say a cashless economy, then in effect you are dealing a heavy blow to that economy of tiny producers, of petty producers, of small producers - the pan wallahs etc etc.

The last point which I wish to make is… You know, I’ve been around for a long time, and I am just staggered by the complete incompetence of economic decision making now. Because in the past, in the government, even those who are ideologically opposed to me, brilliant minds - I.G. Patel, K.S. Krishnaswami, Raghuram Rajan… the Government of India always was served by very brilliant economic bureaucrats. Whether you agree with them or not, nonetheless, they were people who had good minds, who actually could think and could, you know, come up with an anticipation of the kinds of problems that would arise.

At the same time, the political leadership was also much more open to listening to discussion. Political leadership may not know economics. I will tell you a story which was told to me by my teacher Prof. K.N. Raj. One day, Indira Gandhi called him and a few others from Delhi School of Economics to her office - she was the Prime Minister at that time - and asked them, “What do you think of bank nationalisation?” So they said “Yeah, yeah, it is a very good idea if we nationalise banks.”. And then she said “Okay, if you think so, can you please make some time and come tomorrow? I want you to talk to somebody else. There was a member of our cabinet, well known ex-communist called Mohan Kumaramangalam who was actually opposed to bank nationalization.” So she wanted to see a debate between Mohan Kumaramangalam and the Delhi School professors and she just listened to it. Indira Gandhi had no knowledge of economics, but at least political leadership was on the one hand open to looking at discussions, looking at issues. And at the same time, professors or bureaucrats or ministers and so on were also people who expressed their views.

Now what you have is a disastrous combination, of a political leadership that doesn’t, of course, know much [laughs from audience] and what is more, you have an economic bureaucracy which is sycophantic. As a result they say what they think the political leadership wants to hear. And this is an utterly disastrous combination. So disastrous that in fact the IMF is now telling the Government of India that while we approve of your desire to get rid of money, please be careful! The fact that in India, the level of economic decision-making has shrunk to a point where India instead of being the model among all the third world countries in terms of the kind of economic bureaucracy it had, now has to get this kind of gratuitous advice from the IMF is really indicative of very very bad days to come.

I do not know how long this particular crisis of cash shortage is going to last. Peasants who have harvested their crops now - the kharif harvest - they are finding it very difficult to sell because there is nobody coming to buy because there is no cash. And this, as I said, is going to affect petty production sectors very seriously. How long this crisis is going to last, I do not know. In fact it now turns out that even the ATMs cannot really function properly because of the fact that they have to be remodelled. And that itself is going to take time because there are not enough technicians and so on. The fact that all these decisions were taken without anticipating these problems is just [indicative of] a level of incompetence that I find staggering, and it is that which actually worries me very greatly.